No foundation wants to face the wrath of the IRS, yet some private foundation managers expose themselves to severe penalties by failing to understand self-dealing rules. Although the seven acts of self-dealing seem straightforward, they can be misunderstood or overlooked by even the most cautious foundation.
To further complicate things, there are lots of misconceptions in the philanthropic sector about what self-dealing rules do and do not cover.
With the right information and support from accounting professionals, self-dealing does not need to be a source of stress for foundations. By having the right policies in place and educating the board and employees on the rules, foundations can avoid common pitfalls.
The Seven Types of Transactions and Disqualified Persons
Per the IRS, the following transactions between a private foundation and a disqualified person are generally considered self-dealing:
Sale, exchange or leasing of property.
Leases (although there are some exceptions).
Lending money or other extensions of credit.
Providing goods, services or facilities.
Paying compensation or reimbursing expenses to a disqualified person.
Transferring foundation income or assets to, or for the use or benefit of, a disqualified person.
Certain agreements to make payments of money or property to government officials.
It’s important for foundations to understand how the IRS defines a disqualified person. Most foundations are aware that foundation managers—including officers, directors and trustees—are considered disqualified persons. And this also extends to their spouses, ancestors, children and grandchildren, as well as the spouses of their children and grandchildren. Interestingly, however, the IRS does not consider siblings to be disqualified persons.
Foundations must also be cautious when dealing with substantial contributors. Under the IRS definition, a substantial contributor is any person who contributes or bequeaths more than $5,000 to the foundation and this amount is more than 2 percent of the total contributions and bequests received by the foundation in the same tax year. For family foundations, substantial contributors also include the person who funded the foundation and their family members.
Substantial contributors retain this status until neither they nor their family members have made a substantial contribution for 10 years.
When a substantial contributor is an entity, such as a corporation or trust, any individual who controls more than 20 percent of it is also considered a disqualified person. Additionally, a corporation, partnership, trust or estate itself is disqualified when a substantial contributor, foundation manager or disqualified family member owns more than 35 percent of it.
Another private foundation is disqualified when the same people effectively control or substantially contribute to it and the foundation in question. Finally, most government officials, including all elected executive and legislative officials, are disqualified.
Some categories of disqualified persons are straightforward. In other cases, a foundation may need to know someone’s ownership stake in a corporation, the amount of their financial contribution or their family relationships to know whether they are disqualified. For this reason, it is crucial that foundations understand IRS rules and do their due diligence so they do not inadvertently enter into a self-dealing transaction.
Advertisement
Common Self-dealing Mistakes Put Foundations at Risk
It is difficult for foundation managers to anticipate all the potential scenarios that could be considered self-dealing, even when they have a general understanding of the rules. Foundations often fall into similar traps.
For example, it is an act of self-dealing when a foundation uses its resources to satisfy the legal obligation of a disqualified person. This may occur when a person makes an enforceable pledge to donate to a charity and subsequently asks their family foundation to satisfy the pledge in their place. In this case, the family foundation would be engaging in self-dealing because the individual is a disqualified person using the foundation’s assets for their personal use.
Another common slip-up is when money is lent or credit is extended between a foundation and a disqualified person. This can happen when a disqualified person uses the foundation’s credit card for a personal expense by mistake. Even if this is an innocent error, it is an act of self-dealing which needs to be corrected and reported.
Family members engaging in self-dealing may be the most frequent pitfall. For example, even though board members are disqualified persons, they can attend charity events, such as galas or award ceremonies, as representatives of the foundation. However, their spouses, children and other disqualified family members cannot attend using tickets paid for by the foundation because they do not have official roles in the foundation. It is not hard to see how a board member might bring their spouse to an event without realizing they are, in fact, violating self-dealing rules.
Misunderstanding Self-dealing Rules Can Hurt in More Ways Than One
Misconceptions about self-dealing can also prevent foundations from accessing useful resources. Foundations may avoid transactions that are perfectly accepted by the IRS because they incorrectly believe they are self-dealing.
For instance, it is a good rule of thumb that a foundation is engaging in self-dealing when it provides or receives goods, services or facilities from a disqualified person. This can include office space, auditoriums, laboratories, administrative assistance, meals, publications, libraries, cars and parking lots.
However, it is not considered self-dealing if the disqualified person provides these resources to the foundation for free.
The IRS also has no issue when the foundation provides such resources to a foundation manager, employee or unpaid worker in recognition of their services when:
The value of the items provided is reasonable.
The resources are necessary to perform a task to carry out the exempt purpose of the foundation.
For example, compensating a disqualified person for providing personal services is acceptable, whether they serve as an employee, an advisor or a director or trustee of the foundation.
How Accounting Professionals Can Help
In most cases, foundations make self-dealing errors simply because of misunderstanding, not because they are intentionally engaging in misconduct. Accounting professionals can help clients in the philanthropic sector avoid self-dealing issues before they happen:
Educate board members. Board members may have varying degrees of familiarity with self-dealing rules. Provide information that foundations can pass on to board members or offer to speak about self-dealing at a board meeting.
Suggest best practices. This includes encouraging clients to perform a compensation study periodically to address any potential violations of the personal services element of self-dealing rules, suggesting that clients adopt a conflict-of-interest policy and establishing a travel and expense reimbursement policy.
Be a source of knowledge on self-dealing. Be available to clients for questions regarding self-dealing, and make sure you have a strong understanding of the rules yourself.
Stephanie Yan is the Private Foundation Practice Leader at GHJ, a national advisory and accounting firm.
